DePaul Law Review
Volume 3
Issue 2 Spring-Summer 1954
Article 7
The Depletion Deduction in the Oil and Gas
Industry for Federal Income Tax Purposes
DePaul College of Law
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DePaul College of Law, The Depletion Deduction in the Oil and Gas Industry for Federal Income Tax Purposes, 3 DePaul L. Rev. 233
(1954)
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COMMENTS
THE DEPLETION DEDUCTION IN THE OIL AND GAS
INDUSTRY FOR FEDERAL INCOME TAX PURPOSES
THE NATURE AND CLASSIFICATION OF THE DEPLETION DEDUCTION
It is often heard in tax circles that the people in the oil and gas industry
are being subsidized by the Federal Government through the allowance of
the depletion deduction in the form of cost depletion or percentage depletion, at the rate of 27 1/2 per cent of gross income, whichever is the greater
of the two. This being the charge, it becomes essential to understand the
establishment and continuance of this allowance as a deduction from income for tax purposes, and the basic reasons why the deduction is allowed
at all. Such an understanding can be acquired only through some acquaintance with the statutes and decisions dealing with the deduction.
Mr. Justice Brandeis stated the reason for the allowance of the depletion
deduction as follows:
The depletion charge permitted as a deduction from the gross income in
determining the taxable income of mines for any year represents the reduction
in the mineral contents of the reserves from which the product is taken. The
reserves are recognized as wasting assets. The depletion effected by operation
is likened to the using up of raw material in making the product of a manufacturing establishment. As the cost of the raw material must be deducted
from the gross income before the net income can be determined, so the estimated cost of the part of the reserve used up is allowed.'
Thus the depletion deduction is only granted in favor of those whose
reserve of their capital asset is being depleted through the extraction of
the oil and gas. Generally speaking, this can be held to be a true statement of the allowance.
The Supreme Court again likened the depletion deduction to the consumption of raw materials in manufacturing:
Oil and gas reserves like other minerals in place, are recognized as wasting
assets. The production of oil and gas, like the mining of ore, is treated as an
income-producing operation, not as a conversion of capital investment as upon
a sale, and is said to resemble a manufacturing business carried on by the use
of the soil....
The granting of an arbitrary deduction, in the interests of
convenience, of a percentage of the gross income derived from the severance
of oil and gas, merely emphasizes the underlying theory of the allowance as a
tax-free return of 2the capital consumed in the production of gross income
through severance.
The depletion deduction is a matter of legislative grace by which Congress allows the oil and gas producer a deduction from his gross income
1 United States v. Ludey, 274 U.S. 295 (1927).
2
Anderson v. Helvering, 310 U.S. 404 (1940).
DE PAUL LAW REVIEW
as a compensation for his capital assets consumed in the production of income through their severance from their places in the earth.
THE HISTORY OF THE DEPLETION DEDUCTION
Since the depletion deduction is a statutory matter, tracing the present
depletion deduction provisions through the various Internal Revenue Acts
which preceded the Internal Revenue Code should result in a better
understanding of said provisions.
Under the Corporation Tax Act of August 5, 1909,8 the Supreme Court
held that no allowance for depletion was to be accorded to a mining
corporation for the purpose of determining its net income.4 This decision
was rendered against the taxpayer corporation even though the deduction
against the gross proceeds from the mining and treatment of ores to the
extent of the cost value of the ore in the mine before it was mined, had
been ascertained in accordance with Treasury Decision 1675. Thus, both
Congress and the Treasury Department had evidently presumed that the
1909 Act as written had allowed a deduction for depletion, but the Supreme Court thought otherwise.
To remedy this confused situation, in passing the Internal Revenue Act
of 1913 Congress allowed for a deduction for depletion by the following
provisions, "in the case of mines a reasonable allowance for depletion of
ores and all other natural deposits, not to exceed 5 per centum of the gross
value at the mine of the output for the year for which the computation is
made."5 This section was later held to include oil and gas wells.
The 1913 Act came under fire in Stanton v. Baltic Mining Co.,6 in
which Stanton, a stockholder of the mining company, sought to enjoin
the voluntary payment by the corporation and its officers of the tax
assessed against it under the 1913 Act, because an inadequate allowance by
way of deduction was made for the exhaustion of the ore body; claiming
the tax was in the nature of things one on property because of its ownership, and therefore a direct tax subject to apportionment. Mr. Chief Justice White stated:
This merely asserts a right to take the taxation of mining corporations out of
the rule established by the 16th Amendment when there is no authority for
so doing. It moreover rests upon the wholly fallacious assumption that, looked
at from the point of view of substance, a tax on the product of a mine is
necessarily in its essence and nature in every case a direct tax on property
because of its ownership unless adequate allowance be made for the exhaustion
of the ore body to result from working the mine. We say wholly fallacious
3 36 Stat. 112 (1909).
Goldfield Consolidated Mines Co. v. Scott, 247 U.S. 126 (1918).
Internal Revenue Act of 1913, S 2 G (b) (as to corporations).
6 240 U.S. 103 (1916).
4
5
COMMENTS
assumption because, independently of the effect of the operation of the 16th
Amendment, it was settled in Stratton's Independence v. Howbert, 231 U.S.
399, 34 S. Ct. 136, that such tax is not a tax upon property as such because of
its ownership, but a true excise levied on the results of the business of carrying on mining operations.7
That the depletion deduction is not required by the 16th Amendment
itself, but is merely allowed as a matter of legislative grace of Congress
will become quite apparent when it is seen how Congress from time to
time has changed and rechanged, clarified and in many cases discarded
provisions for depletion deduction under the various Internal Revenue
Acts.
Change in the provisions of the 1913 Act were soon made for the oil
and gas industry. In 1916 the Congress provided:
In the case of oil and gas wells a reasonable allowance for actual reduction in
flow and production to be ascertained not by the flush flow, but by the settled
production or regular flow; . . . such reasonable allowance to be made . . .
under rules and regulations to be prescribed by the Secretary of the Treasury:
Provided, That when the allowance authorized . . . shall equal the capital
originally invested, or in the case of purchase made prior to March 1, 1913,
the fair market value as of that date, no further allowance shall be made .... 8
Under this Act the total depletion deductions allowed over the years
were to be limited to the capital originally invested, or to the fair market
value as of March 1, 1913. This limitation provision is to disappear ten
years later with the introduction of the "percentage depletion" concept.9
The depletion deduction became unlimited as long as income continued to
be derived from the operation of the oil or gas well. This lack of a limitation is one of the points that is criticized adversely by those people who
would have Congress abolish the depletion deduction.
Of the 1916 Act provision, an Ohio federal district court in Ohio Oil
Co. v. United States stated:
The statute states that there may be deducted a reasonable allowance for the
actual reduction in flow and production to be ascertained not by the flush
flow but by the settled production or regular flow. "Flush flow" indicates
that flow of the oil when it is forced by natural pressures out of the ground
from wells commonly known as gushers, or it may refer to the natural flow
of other wells before they have reached the state where it is necessary that
the oil be pumped. "Settled production" refers to the period in the life of an oil
well which follows immediately after the flush flow. At that stage the oil
must be pumped and the yield is called "settled production." "Regular flow"
is perhaps a misnomer, for it seems upon this record that it is generally recognized in the industry that the flow is never regular. Its tendency is to be irregular. This was recognized by members of Congress.
7 Ibid, at 113.
8Internal Revenue Act of 1916, § 12 (b) second (b) (as to corporations).
9Internal Revenue Act of 1926, § 204(c) (2).
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LAW REVIEW
I have concluded that in using the term "regular flow," Congress intended
to use the term synonymously with the term "settled production," which had
a rigid and fixed meaning in the industry. 10
The court then viewed the practices within the oil industry:
At the time the 1916 Act became law, two methods for the computation of
depletion were being considered, namely, (1) the decline in flow method also
known as "reduction in flow" and "inventory of production" methods; and
(2) the ultimate production method also known as the "unit method." The
decline of flow method contrasted the daily average production of the last
day of the year with the last day of the previous year, thus determining the
decrease in the daily average production.
The ultimate production method is predicated upon the assumption that
it is possible to determine with reasonable accuracy the total amount of oil
or gas which is under ground and which will be produced from a given lease
or other unit of oil producing property during its commercially productive
life. The initial step in this method is the estimation of the number of barrels
of oil that will be ultimately extracted from a specified property. The investment in the property is divided by the number of barrels estimated, giving
the unit cost or value attributable to each barrel of oil under ground. As the
oil is extracted, an allowance of such unit is made for each barrel recovered,
so that the depletion allowance for the year is the unit multiplied by the
number of barrels of oil produced.
For many years prior to the time that the Income Tax Act of 1916 was
under consideration by Congress, it had been the practice in the oil industry
to buy and sell oil properties on the basis of their daily average production.
Such properties were sold and the price fixed at a given price per barrel for
such daily average production. The decline in flow method of determining
depletion or exhaustion in its narrower sense grew naturally out of this practice. It was generally regarded as an accurate method of determining depletion
especially by operators who did not long retain properties and whose purpose
was to sell them as soon as they reached settled production. In the absence of
any more accurate method, it was natural to arrive at the conclusion that the
decrease in the daily average production measured the exhaustion and decline
of the reserves of oil for given properties.
The ultimate production method came later. It was based upon the supposition that the amount of oil underlying a particular property could be
measured with sufficient accuracy to serve as a basis for a determination or
ascertainment of the exhaustion and depletion of the reserves.
The decline in flow method proceeded upon the theory that the amount
of recoverable oil could more accurately be determined by the regular flow
as settled production, which indicated the amount of oil which had actually
been recovered from the reserves. The ultimate production method was predicated upon the thought that the amount of the reserves could be determined
in advance of the recovery of the oil from the reserves."
With these accepted methods of computing depletion in use in the
industry at the time of the drafting and subsequent passage of the 1916
10 Ohio Oil Co. v. United States, 17 A.F.T.R. 1114(1936).
11 Ibid.
COMMENTS
Act 12 it is interesting to view the proceedings in Congress as of that time
to see what method the Congress thought it had employed in the passage
of the statute. Senator Chilton, of West Virginia, was largely responsible
for the phraseology of the bill. He stated that the expressions "flush flow"
and "settled production" were perfectly well understood among oil men
and producers. "They are well known to the operators and to the men
who own the land... .",u1From the Senate discussions it appeared that the
senators had in mind permitting the deduction of depletion as the decline
in the flow after the wells had reached settled production or regular flow,
but, they regarded the provisions of the 1913 Act (5 per centum of the
gross value at the mine 14) as arbitrary and as not permitting a sufficient
allowance for depletion. Congress appreciated that a provision must be
applied in the case of oil and gas properties different from that which was
to be applied in metallic and other mining properties. This appreciation
evidenced itself in the form of the final adoption of the 1916 Act separating oil and gas from the other mining properties. This separation has
continued in existence through all subsequent acts.
Congress thus based the depletion deduction on the "decline in flow
method." Depletion was not allowed upon a method which presupposed
that the reserve of oil or gas under ground could be accurately estimated
so that a fixed unit depletion 15 could be allowed upon each barrel produced, but the depletion deduction was allowed on the basis of a known
average daily production computed from the actual oil taken from the
well. That the confused rules for the computation of the depletion deduction still bothered the Congress can be seen from the wording of the 1918
Act, in which Congress shifted the burden of prescribing a formula to the
Commissioner of Internal Revenue.
The 1918 Act provided for the depletion deduction as follows:
In the case of . . . oil and gas wells.... a reasonable allowance for depletion
... according to the peculiar conditions in each case, based upon cost including cost of development not otherwise deducted: Provided, That in the
case of such properties acquired prior to March 1, 1913, the fair market value
of the property (or the taxpayer's interest therein) on that date shall be taken
in lieu of cost up to that date: Provided further, That in the case of .. .oil
and gas wells, discovered by the taxpayer, on or after March 1, 1913, and not
acquired as the result of purchase of a proven tract or lease, where the fair
12
Internal Revenue Act of 1916, § 12 (b) second (b) (as to corporations).
13 53 Cong. Rec., Pt. 13, at 13285-13288 (Sen., Aug. 28, 1916).
14
Internal Revenue Act of 1913, §2 G (b) (as to corporations).
15 Today what is known as "cost depletion" or "unit depletion" is allowed as an
alternative to "percentage depletion." It seems that as science progressed and oil
and gas reserves could be quite accurately estimated, the Congress has recognized
this fact and allowed depletion to be computed based upon such an estimated
reserve.
DE PAUL LAW REVIEW
market value of the property is materially disproportionate to the cost, the
depletion allowance shall be based upon the fair market value of the property
at the date of discovery, or within thirty days thereafter; such reasonable
allowance in all the above cases to be made under rules and regulations to be
prescribed by the Commissioner with the approval of the Secretary. In the
case of leases the deductions allowed by this paragraph shall be equitably
apportioned between the lessor and lessee. 10
In comparing the language of the 1916 and 1918 Acts in the Ohio Oil
Company case the court stated:
Under the 1918 Act it was open to the Commissioner and the Secretary of the
Treasury to adopt either the decline in flow or the ultimate production method, but the 1918 Act did not contain the language "in the case of oil and gas
wells a reasonable allowance for the actual reduction in flow and production,
to be ascertained not by the flush flow, but by the settled production or
regular flow." . . . It may be said in passing, however, that while there may
have been weaknesses in the decline in flow method the ultimate production
method was not free from criticism. There was grave doubt as to whether
or not the reserves could be reasonably accurately estimated for income tax
purposes. It was adopted by the Bureau, but in the Revenue Acts of 1926, 1928,
1932, 1934 [1936, 1938, and the Internal Revenue Code] Congress again resorted
to the percentage method as an alternative. 17
Even under the 1918 Act, Congress, although agreed that a depletion
deduction should be granted in the oil and gas industry, still had not agreed
as to how to compute said deduction. The Congress under this Act very
definitely shifted the burden of prescribing a formula for computing the
depletion deduction to the Commissioner of Internal Revenue and the Secretary of the Treasury. Mr. Justice Roberts put the matter in these words:
It is clear that Congress intended that the lessee of an oil well should be entitled to a reasonable allowance for depletion based upon cost or March 1,
1913 value. It did not however attempt to prescribe a formula for ascertaining
it, but expressly delegated that function to the Commissioner of Internal
Revenue, who was to make rules and regulations to that end.' 8
The proviso allowing for "discovery depletion" in this Act was to have a
hectic existence, to cause untold administrative troubles and confusion and
ultimately was to be discarded for the more simple administrative method
known as "percentage depletion."
It is because of the administrative problems created by "discovery depletion," that Congress began to limit the provision allowing for "discovery
depletion." These limitations manifest themselves in the 1921 Act which
provides:
In the case of .. . oil and gas wells .... a reasonable allowance for depletion
...
according to the peculiar conditions in each case, based upon cost includl Internal Revenue Act of 1918, S 234 (a) (9) (as to corporations).
17 Ohio Oil Co. v. United States, 17 A.F.T.R. 1114 (1936).
18 Bumet v. Thompson Oil and Gas Co., 283 U.S. 301, 304 (1931).
COMMENTS
ing cost of development not otherwise deducted: Provided, That in the case
of such properties acquired prior to March 1, 1913, the fair market value of
the property (or the taxpayer's interest therein) on that date shall be taken
in lieu of cost up to that date: Provided further, That in the case of... oil
and gas wells discovered by the taxpayer on or after March 1, 1913, and not
acquired as the result of purchase of a proven tract or lease, where the fair
market value of the property is materially disproportionate to the cost, the
depletion allowance shall be based upon the fair market value of the property
at the date of the discovery or within thirty days thereafter: And provided
further, That such depletion allowance based on discovery value shall not
exceed the net income, computed without allowance for depletion, from the
property upon which the discovery is made, except where such net income
so computed is less than the depletion allowance based on cost or fair market
value as of March 1, 1913; such reasonable allowance in all the above cases to
be made under rules and regulations to be prescribed by the Commissioner
with the approval of the Secretary. In the case of leases the deductions allowed
by this paragraph shall be equitably apportioned between the lessor and
lessee. 19
The Conference Committee reported on this section of the Act as fol-
lows:
Amendment No. 189: This Amendment inserts, . . . the paragraph of the
existing law relating to depletion allowance in the case of . . . , oil and gas
wells . . . , adding a proviso that the depletion allowance based on discovery
value shall not exceed the net income from property upon which the discovery is made except where such net income is less than the depletion
allowance based on cost or fair market value as of March 1, 1913.20
This proviso limiting the depletion allowable based on discovery value,
prevented a corporation engaged in any other business from taking any
part of its depletion allowance against its income from other sources. The
depletion allowance based on discovery value was now such that it would
not exceed the net income from the oil property upon which the discovery was made. Under the law prior to the 1921 Act there was no
such limitation.
The Circuit Court of Appeals, Second Circuit, in discussing the depletion
provision of the 1921 Act held that depletion is regarded for tax purposes
as a return of capital, and not as a special bonus for enterprise. 21
It was the provision for "discovery depletion" which continued to cause
administrative problems, and as these problems grew, Congress revamped
the depletion deduction section to clarify and further limit the "discovery
depletion" allowance.
This revamped section on depletion appeared as part of the 1924 Act.
The 1924 Act separated, for the first time, into separate sections2 2 the deple19 Internal Revenue Act of 1921, S 234(a) (9) (as to corporations).
20
21
22
H. R. Rep. No. 486, 67th Cong. 1st Sess. (1921).
Untermyer v. Commissioner, 59 F. 2d 1004, (C.A. 2d, 1932).
Internal Revenue Act of 1924, S§204(c) and 234(a) (8).
DE PAUL LAW REVIEW
tion deduction allowance provision from the provision which set forth the
basis upon which the depletion deduction was to be allowed. Thus Section
234(a) (8) (as to corporations) dealing with the allowance itself reads:
In the case of .... oil and gas wells, . .. a reasonable allowance for depletion
.... according to the peculiar conditions in each case; such reasonable allowance in all cases to be made under rules and regulations to be prescribed by
the Commissioner with the approval of the Secretary. In the case of leases
the deductions allowed by this paragraph shall be equitably apportioned between the lessor and lessee.
Section 204(c), dealing with basis reads:
The basis upon which depletion ....
are (is) to be allowed in respect of any
property shall be the same as provided in subdivision (a) or (b) for the purpose of determining the gain or loss upon the sale or other disposition of such
property, except that in the case of . . . oil and gas wells, discovered by the
taxpayer after February 28, 1913, and not acquired as the result of purchase
of a proven tract or lease, where the fair market value of the property is
materially disproportionate to the cost, the basis for depletion shall be the fair
market value of the property at the date of discovery or within thirty days
thereafter; but such depletion allowance based on discovery value shall not
exceed 50 per centum of the net income (computed without allowance for
depletion) from the property upon which the discovery was made, except that
in no case shall the depletion allowance be less than it would be if computed
without reference to discovery value.
Section 234(a) (8) in setting forth that the depletion allowance under
this Act shall be in accord with rules and regulations prescribed by the
Commissioner with the approval of the Secretary was the same as' in the
then existing law. As to section 204(c), however, the Committee Reports
of the Ways and Means Committee stated:
(9) The first part of subdivision (c) of the bill, that is, the part preceding
the exceptions, does not correspond to any provision of the existing law, but
is the same as the interpretation placed upon the existing law by the department. It provides that the basis of computing depreciation and depletion shall
be the same as the basis of computing gain or loss from the sale of property,
and represents what is obviously the correct rule, since the theory in setting
a basis for depreciation and depletion is the same as in setting one for determining gain or loss from sale; that is, to insure a taxpayer a return of his
capital free from tax. (10) The last part of subdivision (c) supersedes the
second and third provisos of section . . . 234 (a) (9) of the existing law. The
existing law limits discovery depletion to the operating profits from the property upon which the discovery is made. The bill limits discovery depletion to
50 per cent of the operating profit upon which the discovery has been made. 23
The Treasury Department, in explanation of proposed changes in the
Act of 192 1, prepared a statement for the use of the Senate Finance Committee which read in part:
2sH.
R. Rep. No. 179,68th Cong. 1st Sess. (1923).
COMMENTS
Experience in administering the law has shown that the limitation imposed by
the existing law is not a sufficient limitation, and it has been concluded that
50 per cent of the operating profit from the property represents a fair limitation upon discovery depletion.
It was the 1924 Act, then, that for the first time tied in the allowance for
depletion with the basis of the property for the purpose of determining gain
or loss upon the sale or other disposition of such property, with the exception of the basis for discovery depletion which remained as it had been.
This act also further limited the allowance for discovery depletion, and it
is in this Act that discovery depletion last appears in the law.
The 1926 Act 24 was the first in this series of acts to provide for percentage depletion in the case of oil and gas properties. In so doing the
Act did away with discovery depletion. Cost depletion continued the
same as it had been in the 1924 Act.
Section 234(a)(8) (as to corporations) of the 1926 Act remained exactly the same as Section 234(a) (8) of the 1924 Act.
Section 204(C)(2) of the 1926 Act sets forth the following:
In the case of oil and gas wells the allowance for depletion shall be 273 per
centum of the gross income from the property during the taxable year. Such
allowance shall not exceed 50 per centum of the net income of the taxpayer
(computed without allowance for depletion) from the property, except that
in no case shall the depletion allowance be less than it would be if computed
without reference to this paragraph.
The question has been asked as to why the figure 27 was chosen
as the percentage of gross income to be allowed as the depletion deduction. The Senate and House reports show that it was a compromise figure
as one might readily suspect. The Senate Finance Committee Report read
in part:
The administration of the discovery provision of existing law in the case of
oil and gas wells has been very difficult because of the discovery valuation
that had to be made in the case of each discovered well. In the interest of
simplicity and certainty in administration your committee recommends that in
the case of oil and gas wells the allowance for depletion shall be 25 per cent
of the gross income from the property during the taxable year. The provision
of existing law limiting this amount to an amount not in excess of 50 per cent
of the net income of the taxpayer from the property is retained. 25
The Conference Committee Report contains this statement of the
House's view:
The administration of the discovery provision of the existing law in the case
of oil and gas wells has been very difficult because of the discovery valuation
that had to be made in the case of each discovered well. In the interest of
24
2
Internal Revenue Act of 1926, §S 204(c) (2) and 234(a) (8).
Rep. No. 52, 69th Cong. 1st Sess. (1925).
5 Sen.
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simplicity and certainty in administration the Senate amendment provides that
in the case of oil and gas wells the allowance for depletion shall be 30 per
cent of the gross income from the property during the taxable year. The provision of existing law limiting this amount to an amount not in excess of 50
per cent of the net income of the taxpayer from the property is retained.
The House recedes with an amendment providing that the depletion deduction based upon gross income in the case of an oil and gas well shall be
26
27ll per cent of that income instead of 30 per cent.,.
This then is how the 27 2 per cent figure came into being, the Senate
Finance Committee recommending a 25 per cent figure as a rule of
thumb, the Senate setting up a 30 per cent figure and the House striking
the happy medium of 27 /2 per cent of gross income as the percentage
depletion deduction to be allowed.
From these Congressional records it is seen that the reason for allowing percentage depletion instead of discovery depletion was based upon
the need for simplicity and certainty in administration. It can be implied
from this that Congress was confused as to the manner of determining
discovery value depletion and, dissatisfied with the then existing administration of the law and in search of a simple and certain law, struck upon
percentage depletion as the answer.
In discussing the 1926 Act along with the prior Acts dealing with
depletion, Mr. Justice Stone said:
There is no ground for supposing that Congress, by providing a new method
for computing the allowance for depletion, intended to break with the past
and narrow the function of that allowance. The reasonable inference is that
it did not, and that depletion includes under the 1926 Act precisely what it
27
included under the earlier acts.
From the same opinion comes this statement by Mr. Justice Stone:
But the "discovery value" provision was eliminated from the Act of 1926,
which is applicable here, and the taxpayer was permitted to calculate depletion
on the basis of cost alone, section 204(c), . . . or else to deduct an arbitrary
allowance, fixed by the statute, without reference
to cost or discovery value,
28
at 27% per cent of gross income from the well.
Mr. Justice Roberts, in discussing the wording of the 1926 Act, said
that in authorizing the allowance, for depletion, of 27 Y2 per cent of
"gross income from the property" during the taxable year in the case
of oil and gas wells, the words "gross income from property" mean only
29
gross income from oil and gas.
Mr. Chief Justice Hughes had this to say of the then new depletion
provision:
26 H. R. Rep. No. 356,69th Cong. 1st Sess. (1925).
27 United States v. Dakota-Montana Oil Co., 288 U.S. 459,467 (1933).
28 Ibid., at 461.
29 Helvering v. Twin Bell Oil Syndicate, 293 U.S. 312 (1934).
COMMENTS
The evident purpose of the statutory provision controls. It is a unique provision to meet a special case. Analogies sought to be drawn from other applications of the revenue acts may be delusive and lead us far from the intent of
Congress in this instance. Congress has recognized that in fairness there should
be compensation to the owner for the exhaustion of the mineral deposits in
the course of production. But to appraise the actual extent of depletion on
the particular facts in relation to each taxpayer would give rise to problems
df considerable perplexity and would create administrative difficulties which
it was intended to overcome by laying down a simple rule which could be
easily applied. To this end, the taxpayer was permitted to deduct a specified
percentage of his gross income from the property. Congress was free to give
such an arbitrary allowance as the deduction was an act of grace. In answer
to the contention that the provision may produce "unjust and unequal results,"
we have remarked that this is likely to be so "wherever a rule of thumb is
0
applied without a detailed examination of the facts affecting each taxpayer.
It is clear that the courts were going to follow the intent of Congress
as to the application of the provision allowing 27 per cent of gross income from the property as the depletion deduction. The gross income
was to be limited to the income derived from the extraction of oil and gas
from the well, and the application was going to be made as simple as possible to enable the law to be more easily administered. Congress had laid
down what to it was a simple rule and the courts as evidenced by the
opinions of the Supreme Court of the United States were going to limit
the application of the law as much as possible to be sure that the rule
remained simple. This Act furnished the basic rules for depletion for
all subsequent statutes.
The 1928 Act 3 ' followed the language of the 1926 Act,3 2 and set out
methods for computing depletion in the cases of life estates followed
by a remainder and of property being held in trust.
The wording of the Revenue Act of 193233 followed that of 1928 with
an added sentence in Section 23(1) which dealt with cost depletion:
In any case in which it is ascertained as a result of operations or of development work that the recoverable units are greater or less than the prior estimate thereof, then such prior estimate (but not the basis for depletion) shall
be revised and the allowance under this subsection for subsequent taxable years
shall be based upon such revised estimate.
Section 114(b)(3) used the same language as the 192634 and 1928 Acts88
but added to the first sentence
Helvering v.Mountain Producers Corporation, 303 U.S. 376, 381 (1938).
3l Internal Revenue Act of 1928, §§ 23 (1), (in) and 114(b) (3).
82 Internal Revenue Act of 1926, S§204(c) (2)and 234(a) (8).
38 Internal Revenue Act of 1932, §§ 23 (1)and 114(b) (3).
80
84
Internal Revenue Act of 1926, SS 204(c) (2) and 234(a) (8).
Revenue Act of 1928, §§ 23 (1), (in) and 114(b) (3).
35 Internal
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excluding from such gross income an amount equal to any rents or royalties
paid or incurred by the taxpayer in respect of the property.
On the addition to Section 23(1) the Senate Finance Committee reported:
The House bill requires a change in the annual depletion allowance where a
new estimate of the number of the recoverable units is made in the light of
subsequent events. The effect of the amendment is shown by the following
example:
A purchased for $1,000 an ore body with estimated recoverable units of
1,000. He removes 500 units and takes depletion deductions aggregating one-half
of his cost, or $500. Subsequently it is ascertained that there remain in the mine
1,500 recoverable units and the original estimate of 1,000 recoverable units is
revised. Under the amendment, his unrecovered cost ($1,000 less $500) would
be spread over the revised estimate of the recoverable units (1,500) with the
result that on each unit thereafter removed he would be allowed a depletion
deduction of 331 cents per unit instead of $1 per unit.
The provision in the House bill has been amended so as to make it clear
that it is also to apply where the revision of the estimate of recoverable units
results from day-to-day operations.3 6
As to the addition to Section 114(b)(3) the Conference Committee
Report reads:
Amendment No. 53: This amendment makes it clear that in computing the
gross income from the property, for the purpose of determining the allowance
for percentage depletion in the case of oil and gas wells, there shall be excluded
from such gross income an amount equal to any rents or royalties paid or incurred by the taxpayer in respect of the property. . . .37
The allowance for depletion is intended to return the loss of capital
which enters into the sale price of the oil produced. It deals with income
realized by production. It has no application to sales in whole or in part
38
of the capital investment, the oil reserve itself.
It seems that at this point the basic law (1926 Act) pertaining to the
depletion deduction as it is today had begun to crystallize as Congress
made no sweeping revisions of the 1926 Act, but merely added clarifying
provisions. The administration of the law was apparently meeting with
the approval of the Congress as the Commissioner still retained the power
to prescribe the rules and regulations for computing the depletion deduction.
The 1934 Act, 9 much the same in text as the preceding acts, contained
clarifying changes to make it plain that depletion is actually allowed
86 Sen.
Rep. No. 665, 72d Cong. 1st Sess. (1931).
H. R. Rep. No. 1492, 72d Cong. 1st Sess. (1931).
88 Badger Oil Co. v. Commissioner of Int. Rev., 118 F. 2d 791 (C.A. 5th, 1941).
89 Internal Revenue Act of 1934, § 23 (m) and 114(b) (3).
87
COMMENTS
under Section 23(m) instead of under Section 114(b)(3). It is interesting
to note that an amendment proposed a 1935 Act to eliminate the depletion
deduction from the law; this amendment was rejected by both the House
and the Senate. It became evident then that certain "pressure groups"
were beginning to "howl" about the subsidizing of the minerals industries through the allowance of the depletion deduction, but fortunately
common sense prevailed in the Congress and the law as set up was al40
lowed to continue in force.
In interpreting the 1934 Act, Judge Murrah wrote:
Historically, the depletion statutes are arbitrary allowances to the recipients of
gross income by reason of their capital investment in the oil and gas in place.
The percentage allowance or "reasonable allowance" is of the gross income
from the property which points only to the income from oil and gas and is
correlated to an investment in oil and gas in place. The formula prescribed by
Sections 23(m), 114(b) (3), having direct relationship to gross income from
sources within its scope (oil and gas wells), is exclusive in its application and
to that extent it is an arbitrary substitute for the fundamental rule against the
taxing of gross income before recovery of capital cost. The taxpayer contends
for a rule which would allow 100% depletion until the cost is returned, then a
"reasonable allowance" or 272%, whichever is greater, on the realization of income, thereafter. Obviously, it was not the intention of Congress in providing
the depletion allowance to grant any such advantage over those not falling
within this category.
Statutory depletion is a "rule of thumb" to meet a special case. It is clear that
it was the Congressional purpose to allow return of capital through statutory
depletion from the date of the acquisition of the depletable interest, so long as
gross income is realized dependent upon the production of oil or gas. Likewise,
it is plain that the taxpayer may not be deprived of this privilege, although the
Commissioner may have erroneously permitted a deduction for cost recovery
by some other formula not now subject to adjustment by reason of the statute
41
of limitations.
From this opinion it can easily be seen that as the statutes allowing
depletion began to crystallize from one Revenue Act to the next, so did
the rulings of the courts and so did the language of the courts. The
courts speak of the arbitrary allowance of percentage (statutory) depletion, they speak always of the congressional intent, and likewise of the
return of the capital investment, this latter even though the allowance
of percentage depletion does not cease once the original capital investment has been fully recovered. 42
40
For some enlightening reading on this point see 78 Cong. Rec.
41 Commissioner v. I. A. O'Shaughnessy Inc., 124 F. 2d. 33 (C.A. 10th, 1941).
42 See: Alphonzo E. Bell Corporation v. Commissioner, 145 F. 2d 157 (C.A. 9th,
1944) as an interpretation of the Internal Revenue Act of 1938, to note the similarity
in rulings and language which the courts have adopted in passing on issues dealing
with the depletion deduction.
DE PAUL LAW REVIEW
The 1936 Act, 43 the 1938 Act,44 and later the Internal Revenue Code 45
all copied the wording of the 1934 Act 46 verbatim, and this language has
remained unchanged to date. It might be well then to set out Sections
23(m) and 114(b)(3) to show the wording as it appears today.
Section 23 (m) Depletion-In the case of ....
able allowance for depletion
. . .
oil and gas wells, ..
,
a reason-
, according to the peculiar conditions in each
case; such reasonable allowance in all cases to be made under rules and regulations to be prescribed by the Commissioner, with the approval of the Secretary.
In any case in which it is ascertained as a result of operations or of development
work that the recoverable units are greater or less than the prior estimate thereof, then such prior estimate (but not the basis for depletion) shall be revised
and the allowance under this subsection for subsequent taxable years shall be
based upon such revised estimate. In the case of leases the deductions shall be
equitably apportioned between the lessor and lessee. In the case of property
held by one person for life with remainder to another person, the deduction
shall be computed as if the life tenant were the absolute owner of the property
and shall be allowed to the life tenant. In the case of property held in trust the
allowable deduction shall be apportioned between the income beneficiaries
and the trustee in accordance with the pertinent provisions of the instrument
creating the trust, or, in the absence of such provisions, on the basis of the trust
income allocable to each.
Section 114(b) (3)-Percentage depletion for Oil and Gas Wells-In the case
of oil and gas wells the allowance for depletion under section 23(m) shall be
273 per centum of the gross income from the property during the taxable
year, excluding from such gross income an amount equal to any rents or royalties paid or incurred by the taxpayer in respect of the property. Such allowance
shall not exceed 50 per centum of the net income of the taxpayer (computed
without allowance for depletion) from the property, except that in no case
shall the depletion allowance under section 23(m) be less than it would be if
computed without reference to this paragraph.
These, then, are the various acts which were promulgated, revised,
discarded, clarified, elaborated upon, and otherwise worked over until
the law as it is today came into being. They reflect the uneasiness of
mind and the discontent of Congress with the early provisions for depletion and also with the administration or lack thereof of each statute in
turn. This is shown by the discarding of one method of computing the
deduction for another in the earlier acts until the 1926 Act 4 7 which was
the basic act to which the subsequent acts looked for their substance and
language. That statute was clarified and elaborated upon by subsequent
acts but never was it changed. Even this seemingly steady state of the
43
Internal Revenue Act of 1936, § 23 (m) and 114 (b) (3).
Internal Revenue Act of 1938, § § 23 (m) and 114 (b) (3).
Internal Revenue Code, §§ 23 (m) and 114(b) (3); 26 U.S.C.A. §§ 23 (m) and 114(b)
(3) (1949).
46 Internal Revenue Act of 1934, §§ 23 (m) and 114(b) (3).
44
45
47
Internal Revenue Act of 1926, §§ 204(c) (2) and 234(a) (8).
COMMENTS
law was attacked in 1935 when an amendment was 'sought which would
have disallowed the depletion deduction in its entirety. It is the legislative
grace of the Congress which has established the depletion deduction
based upon the risks inherent in the industry as to the chances of drilling
a producing well and also allowing for the return of the capital which
has been invested in a wasting asset. It can well be that some day Congress may see fit to withdraw its legislative grace and this then will leave
the industry without the inducement of a tax benefit as compensation for
the further exploration and subsequent extraction of these vital natural
resources, oil and gas.
COST DEPLETION AND PERCENTAGE DEPLETION
Before proceeding with a discussion of the law as it is today, it might
be helpful to those readers unfamiliar with the methods of computing
cost or percentage depletion to run through an example computation for
each of the two methods. Cost depletion is allowed under Section
39.23(m) of the Internal Revenue Code,4 s Regulations 118 and computed under Section 39.23(m)(2) which reads as follows:
The basis upon which depletion, other than ... percentage depletion, is to be
allowed in respect of any property is the basis provided in section 113(a),
adjusted as provided in section 113(b) for the purpose of determining the
gain upon the sale or other disposition of such property. If the amount of the
basis as adjusted applicable to the mineral deposit has been determined for the
taxable year, the depletion for that year shall be computed by dividing that
amount by the number of units of mineral remaining as of the taxable year,
and by multiplying the depletion unit, so determined, by the number of units
of mineral sold within the taxable year. In the selection of a unit of mineral
for depletion, preference shall be given to the principal or customary unit or
units paid for in the products sold, such as tons of ore, barrels of oil, or thousands of cubic feet of natural gas.
Example Problem:
Suppose that "X" purchases an interest in a producing oil well for
$1,000.00; it is estimated that the recoverable oil is 10,000 barrels. The oil
sells for $2.50 per barrel, and there is recovered for the current year
1,200 barrels of oil which are all sold. Expenses plus depreciation on
equipment equal $1,500.00. The following computation is necessary to
determine the cost depletion to be deducted:
Formula:
Cost depletion
=
Cost of interest to "X"
Estimated barrels recoverable X barrels recovered
Cost depletion = $1,000.00
10,000
4
8 Also, 26 U.S.C.A. S 23(m) (1949).
1200 = $120.00
DE PAUL LAW REVIEW
In determining cost depletion, there are three essential elements that
enter into the computation, namely (1) the basis, (2) number of barrels
sold during the taxable year, and (3) the estimated oil reserve under
ground. This is the information necessary to make the computation.
Percentage depletion is allowable under Section 39.23(m) and is set
forth under Section 39.114(b)(3) and is computed under Section 39.23
(m) (4) which reads:
Under section 114(b)(3), in the case of oil and gas wells, a taxpayer may
deduct for depletion an amount equal to 27,2 per cent of the gross income from
the property during the taxable year, but such deduction shall not exceed 50
per cent of the net income of the taxpayer (computed without allowance for
depletion) from the property. (For definitions of "gross income from the
property" and "net income of the taxpayer (computed without ailowance for
depletion) from the property," see section 39.23(m)(1) (f) and (g).) In no
case shall the deduction computed under this section be less than it would be if
computed upon the cost or other basis of the property provided in section 113.
Example Problem
Taking the set of facts set out in the above example on cost depletion,
then the percentage depletion deduction computation follows:
Formula:
Percentage depletion = Barrels sold X Selling price
per barrel X 27 YA%
Percentage depletion = 1200 X $2.50 X 27Y/% = $825.00
Net income for limitation = Barrels sold X Selling price per
barrel - (expenses + depreciation)
Net income = (1200 X $2.50) - $1500.00 = $1500.00
50% of net income = $750.00
In computing percentage depletion allowable, we look to the gross
income from the property, and as a limitation of the allowable depletion
we look to the net income.
THE STATUS OF THE LAW TODAY
Present statutes permit the deduction from gross income of the higher
of cost or percentage depletion. In the problem above we would then
have to compare the cost and percentage depletion figures to determine
which one is the higher and so deductible from the gross income. The
figures follow:
Cost depletion = $120.00
Percentage depletion = $825.00
Limited to 50% of net income = $750.00
COMMENTS
The proper deduction under the law would be $750.00, which is the limitation of the percentage depletion to 50 per cent of net income.
The necessity for a comparison between cost and percentage depletion
has been put in these words:
From the stipulation it appears that the return contained the usual facts for
computation by both methods and it also appears that the return shows that
the unit (cost) method deduction would be lower than the percentage method.
The stipulation contains all the facts and among them is a statement showing
as to each property the figures in separate columns of gross sales, net income,
unit depletion, 27% per cent of sales, 50 per cent of income, and the allowable
depletion resulting from the applicable method, being sometimes one and sometimes the other. This is because under the last clause of section 114(b) (3) the
allowance under the percentage method may in no case be less than under the
unit method. To one using the percentage method a computation by the unit
method is always necessary, for "in no case shall" the allowance be less than
such a computation shows. This is mandatory.
And it is important that it should be mandatory. Section 114 is primarily one
which prescribes the basis not only for depreciation and depletion, but also
for future determination of gain or loss from sale or other disposition. Thus the
larger depletion serves to reduce the remaining basis and to increase a taxable
gain or reduce a tax reducing loss in the future. 49
It can be seen that in every case the comparison between cost (unit)
depletion and percentage depletion must be made and the higher of the
two will apply as the deduction from gross income. The taxpayer has
no choice in the matter as to which of the two methods he will use,
after making the computations under each method; he is then obliged to
use the higher of the two methods in taking his deduction.50
Mr. Justice Brandeis in United States v. Ludey 5' likened depletion to
depreciation in requiring that the depletion allowed or allowable is
chargeable to a reserve to be used in computing the cost basis of the
property at any time and especially at the time of sale of the property.
Justice Brandeis said:
We are of the opinion that the revenue acts should be construed as requiring
deductions for both depreciation and depletion when determining the original
cost of oil properties sold. Congress, in providing that the basis for determining
gain or loss should be the cost or the 1913 value, was not attempting to provide
an exclusive formula for the computation. The depreciation charge permitted
as a deduction from the gross income in determining the taxable income of a
business for any year represents the reduction, during the year, of the capital
49
Producers Oil Corp. v. Commissioner, 43 B.T.A. 9 (1940).
50
On this see also, Sabine Royalty Corp. v. Commissioner, 17 T.C. 1071 (1951),
where the petitioner erroneously used percentage depletion as a deduction for a number of years and the respondent computed the petitioner's new cost basis by using the
greater cost depletion which was allowable in those years but unclaimed by the
petitioner.
51274 U.S. 295 (1927).
DE PAUL LAW REVIEW
assets through wear and tear of the plant used. The amount of the allowance
for depreciation is the sum which should be set aside for the taxable year, in
order that, at the end of the useful life of the plant in the business, the aggregate
of the sums set aside will (with the salvage value) suffice to provide an amount
equal to the original cost. The theory underlying this allowance for depreciation is that by using up the plant a gradual sale is made of it. The depreciation
charged is the measure of the cost of the part which has been sold. When the
plant is disposed of after years of use, the thing then sold is not the whole
thing originally acquired. The amount of the depreciation must be deducted
from the original cost of the whole in order to determine the cost of that disposed of in the final sale of properties. Any other construction would permit
a double deduction for the loss of the same capital assets.
Such being the rule applicable to manufacturing and mercantile business, no
good reason appears why the business of mining should be treated differently.
The reasons urged for refusing
to apply the rule specifically to oil mining
52
properties seems to us unsound.
This then is the depletion deduction today: it is an arbitrary deduction
allowed by the Congress to allow for the recovery of capital invested in
the oil or gas in the earth; it also allows a deduction to continue after
the total capital invested has been recovered; this was probably allowed as
a reward for an extrahazardous enterprise in order to encourage new
production. The taxpayer is obliged to compute both the cost and percentage depletion deductions, and then claim the higher of the two on
his return. Once having claimed the proper amount allowable the taxpayer must set up that amount in a reserve account, such amount to
be used in computing his cost basis of the property upon the sale of the
same at some subsequent date.
What would likely occur in the industry were the Congress to deny
the depletion deduction as some interests still clamor that it do? If Congress were to reduce or completely deny the depletion deduction, it
would constitute a serious curtailment of the incentive to search for
more oil, with a resulting reduction of crude oil reserves in this country.
Under normal times, this would be serious enough, but with today's
international unrest any reduction in oil reserves might well be disastrous.
The effect upon the consumers of oil or gas or their by-products would
be quite heavily felt, as the price of oil and gas products is largely
made up of corporate taxes and to tax such corporations more heavily
will result in a substantial increase in the price of all oil and gas products.
So there is a fairness to the public in general which would be impaired
by increasing the taxes of oil and gas corporations through the reduction
in or doing away with the depletion deduction.
Congress has to date seen fit to go along with the industry and allow
the depletion deduction which developed out of much turmoil, but, as
52
Ibid., at 300.
COMMENTS
it has developed, has been upheld and even lauded by the courts. To
those who seek to have the depletion deduction abolished, it can be said
that if the government has seen fit to give the oil and gas industries a tax
benefit in the form of the depletion deduction, then that benefit has also
inurred to the government itself through increased oil reserves which are
so vital to the economy and the defense of the nation, and to the general
public in the form of lower prices on oil and gas products and in the
abundance of these products. Any benefit that the government might
derive from increased revenues through the decreasing or abolishing of
the depletion deduction allowance seems to be greatly outweighed by
the existence of a thriving and expanding oil and gas industry.
DISINTERMENT
The basis for disinterment is fairness, human emotion and reasonableness. Hence, as is apparent, the issue of exhumation is relegated for determination to courts of equity.1 By early English law ecclesiastical courts
2
had jurisdiction over questions relating to the disposition of a dead body.
This view, however, has never been accepted in the United States, where
equity jurisdiction prevails over questions of this type. Ecclesiastical law
neither governs nor determines equitable rights.8 The court will not order
a body to be disinterred without a very strong showing by the petitioner
that disinterment is necessary and required for the furtherance and in the
4
interests of justice.
1Slifman v. Polotzker Workingmen's Benevolent Assn., 198 Misc. 373, 101 N.Y.S.
2d 826 (1950); Koon v. Doan, 300 Mich. 662, 2 N.W. 2d 878 (1942); Uram v. St.
Mary's Russian Orthodw Church, 207 Minn. 569, 292 N.W. 200 (1940); King v.
Frame, 204 Iowa 1074, 216 N.W. 360 (1926).
2Slifman v. Polotzker Workingmen's Benevolent Assn., 198 Misc. 373, 101 N.Y.S.
2d 826 (1950).
3
Yome v. Gorman, 242 N.Y. 345, 152 N.E. 110 (1926); In re Donn, 14 N.Y.S.
Supp. 189 (1891): "While we grant to all religious organizations the largest and
broadest latitude and liberty to adopt all or any proper rules or regulations, to the
end that their votaries may worship God according to the dictates of their conscience, we have jealously watched and resented any and all attempts on their part
to usurp powers or authority outside or beyond their legitimate functions of caring
for and administering spiritual affairs. While it cannot be said that a corpse is
property in the sense that it is subject to barter and sale, the courts of this country
have recognized the right and authority of the next of kin, in proper cases, to control
and possess it; and when an ecclesiastical body assumes jurisdiction and control over
a corpse its acts are of a temporal and judicial character, and not in any sense
spiritual and, under our laws and institutions, when it attempts so to do it is acting
outside its proper jurisdiction and doman."
4Goodman v. Ind. Order Bickur Cholem Ukadishu, 326 Ill. App. 25, 60 N.E. 2d
892 (1945): "Jewish law as such is no more to be followed in Illinois than is Chinese
law"; Goldman v. Mollen, 168 Va. 345, 191 S.E. 627 (1937); Cabe v. Parker-GrahamSexton, Inc., 202 N.C. 176, 162 S.E. 223 (1932).